FIN3403 LECTURE GUNTER Monday October 13th 2014 1 Disclaimer These notes were prepared by a student enrolled in Melody Gunter s FIN3403 Fall 2014 course and were compiled for Exam 2 These notes contain all materials discussed during lecture on October 13th 2014 and aim to serve as a partial conceptual review for strictly Exam 2 Studying these notes alone will not guarantee you a passing grade It is highly recommended you combine the review of these notes with the review of notes from other lecture dates that you may have missed in addition to extensive practice using your TI BA II Plus on calculation problems Happy studying An important note In this lecture last lecture before Exam 2 scheduled for Wednesday October 15th Gunter introduced a topic that was supposed to fit in the previous lecture but must have been missed It is important to understand this topic conceptually in preparation for the exam Credit Spread and Base Rate Bond Concepts Credit spread is the spread between the Treasury securities usually 10 year and non Treasury securities that are identical in all respects except quality rating In other words credit spread is the difference between yields on treasuries and those on single A rated industrial bonds o A company must offer a higher return on their bonds because their credit is worse than the government s The base rate is the basis for determining lending rates An important note you wont be asked to calculate the Accounting Rate of Return on the exam Just understand the conceptual points and know that it is not a good tool for analyzing capital budgeting decisions and why The rest of these lecture notes will refer to a document that Gunter has posted on blackboard For this current semester Fall 2014 you should be able to see the document in an announcement called Monday s class and it is called Chapter 9 Example for students doc Download this document and have it opened as you review these notes Basic Capital Budgeting Example from supplemental document This example is showing you how to perform a NPV calculation on your TI BA II Plus An important note for NPV and IRR calculations we will not be using the time value of money buttons that we re so used to using N I Y PV PMT FV o We will be using the CF NPV and IRR buttons above the time value of money buttons o Make sure you clear your work EVERY time you begin a new problem You will not be clearing your work like you would for TVM problems you will be using the 2nd CE C to clear work from cash flows Payback calculation o All you re doing here is seeing how long it takes to receive your initial investment from the future cash flows 2 FIN3403 LECTURE GUNTER Monday October 13th 2014 As you subtract out those cash flows from the initial investment resulting in positive values you would count each subtraction as a year or period Once you get to a point where you are about to subtract a cash flow from a value that is less than that cash flow you have run into a situation in which you re not counting the entire year but a portion of that year In the example after subtracting the first two years of cash flows from the initial investment the amount of initial investment left to earn is 30 000 However the next cash flow for year 3 is 95 000 which is larger than the 30 000 that is left So simply divide 30 000 by 95 000 to get the partial year In this particular example 30 000 95 000 leaves us with 32 Add that 32 to the two years you ve accounted for and voila Discounted payback calculation o This is the same type of problem as before however instead of using the cash flows in their raw and stated form you would need to discount each cash flow to t 0using your calculator and then redo the payback calculation Clue remember that your discounted payback period will always be longer larger than your regular payback period because you are discounting each future cash flow to t 0 meaning that each cash flow will be reduced meaning that each cash flow will contribute less to earning back the initial investment which causes a longer time to recoup that investment Keeping the above clue in mind you would be able to automatically eliminate any option on an exam for discount payback period that is less than the regular payback period o You would enter cash flows the same way you would for an NPV calculation as explained above however instead of computing NPV you would compute IRR Remember that IRR is the rate at which NPV for a project would equal IRR calculation NPV Profile from supplemental document 0 For conventional cash flows all future cash flows being positive the NPV profile curve will always be downward sloping and cross the NPV 0 point at the IRR This curve helps us see where our required rate of return would cause NPV to be less than 0 zero or above rejected o Remember we want to only consider projects and investments with NPV of o If a discount rate leads to an NPV that is below zero that project should be For non conventional cash flows multiple changes in future cash flows from positive to negative the NPV profile curve will hit the NPV 0 line at multiple points FIN3403 LECTURE GUNTER Monday October 13th 2014 3 o How could there be two different internal rates of return Well if you use your calculator to determine the internal rate of return for non conventional projects you will compute just one of these points Thus you don t want to need to calculate IRR for non conventional projects It would be considered useless under these circumstances NPV will still be a trusted tool however Modified Internal Rate of Return from supplemental document This is an IRR measure that would be computed for non conventional projects with You wont need to understand how to calculate a modified IRR you just need to non conventional cash flows understand this point conceptually Used as a more meaningful IRR for projects in which there are two or more internal rates of return In a basic sense MIRR takes every negative cash flow figures out the borrowing rate discounts the negative cash flows to t 0using that borrowing rate and finds the future value of the positive cash flows using an investment rate which would then serve as a positive cash flow in the latest year An important note since you are discounting all outflows to t 0 and calculating the future value of all inflows in the latest year there will be no cash flows in the in between years o The negative value you compute from discounting all negative cash flows at some borrowing rate
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